It's Not Aggregate Demand, Stupid

If you were given $1,000, would you spend it immediately or place it in your bank account for future consumption? How about if you were given $1 million? One trillion? At what point would you douse your pile of newly acquired pile of greenbacks in lighter fluid and set them ablaze, as all your possible wants have been satisfied?Human demand is infinite. As economist Ludwig von Mises theorized nearly a century ago, people act in order to achieve ends. If all wants are satisfied, then man does not act.

If you have had the pleasure of listening to mainstream economists in the higher reaches of academia or on the New York Times editorial page, you have been told that the current economic slump in the U.S. is due to a lack of aggregate demand. The conventional wisdom goes like this: consumers, who are deleveraging large amounts of accumulated debt, have cut down on spending. Businesses see a lack of demand and are reluctant to invest in new equipment and hiring. Therefore, the government must take up the slack. How else will the overly simplified macroeconomic formula of consumption + investment + government = GDP be maximized?

Since consumer expenditures make up 70% of the economy, the "lack of aggregate demand" explanation behind economic slumps seems simple enough. To Keynesians, the economy is a circular machine than just needs a measly trillion dollar injection to spin faster.

But herein lies the problem. Economics is called a dismal science not because of its simplicity, but because of its complexity.

If Congress could just spend endless amounts of money to supplement consumption, then the Great Depression would have ended a decade sooner and the current unemployment rate wouldn't be hovering around 9%. As Harvard economist Greg Mankiw recently pointed out, not enough juicing of aggregate demand is never the whole story:

University of Chicago economist Casey Mulligan offers a challenge to that view. Casey points out that there is a regular surge in teenage employment during the summer months because more teenagers are available to work (that is, the supply of their labor has increased). That is no surprise: It is normal supply and demand in action. But if aggregate demand were the main constraint on employment, this increase in supply should not translate into higher employment during deep recessions such as this one. But it does!

What's at work here is the fundamental concept of Say's Law that Keynes failed to disprove: markets clear. A perceived lack of aggregate demand doesn't mean products won't get purchased. Every consumer good is bought if the price falls low enough. Producers must find this price in order to adopt a new production structure to begin meeting this demand. Most people aren't going to pass up a 36-inch television for $5 at Best Buy. Sure, the television producer may fail to garner a profit on this new sales price, but that is why price signals are so important. They tell producers the structure of production can be adjusted in order to meet this new equilibrium. Capital not allocated to producing 36-inch televisions means investment in more profitable operations.

Armchair economists like to assume that human action is predictable and calculable. But action, based solely on individual preference, isn't measurable with econometric formulae.

Increased production financed through accumulated savings drives sustainable growth. This goes hand in hand with entrepreneurial seeking of unmet demand, not aggregate demand in general. Steve Jobs didn't create the iPod because consumers were spending at Walmart. He speculated that there was a demand for a portable device that could store a massive amount of music, designed the product, determined the marginally profitable price it could be sold at, and decided whether or not to risk his capital and make the whole thing happen. He could have been wrong, but thankfully for all of us, he wasn't.

Keynesian focus on aggregate demand misses the big picture. Taken to its extreme conclusion, overconsumption can ultimately lead to higher prices as supply diminishes and production can't keep up. Inflation only exacerbates the situation as wages and prices eventually adjust after distorting the structure of production.

Meanwhile, the real barriers holding back economic growth are unacknowledged by government apologists acting as economists. The prospect is what Robert Higgs deems "regime uncertainty," where the threat of increased taxes and regulatory enforcement is simply tossed away with academic hand-waving. Artificially low interest rates from the Fed have disincentivized savings and pushed investment toward riskier assets. Capital becomes difficult to accumulate, and the economic pie is prevented from expanding.

Aggregate demand is the last vestige of economists who believe that prosperity is but a simple math formula away. Those who hold it truly believe that government spending on anything creates wealth. As Paul Krugman admitted:

As far as creating aggregate demand is concerned, spending is spending - public spending is as good as but also no better than private spending, spending on bombs is as good as spending on public parks.

Such a candid statement reveals the true nature of Keynesianism. Any merit it had as an economic theory has been replaced with providing cover for politicians to do what they do best: fund special interests. When digging ditches became a solution to joblessness, Keynesianism should have been relegated to the dustbin of history. Instead, it litters college textbooks to this day.

With theories like this passing as conventional wisdom, is it any wonder why our economic affairs are in such disarray?

If you were given $1,000, would you spend it immediately or place it in your bank account for future consumption? How about if you were given $1 million? One trillion? At what point would you douse your pile of newly acquired pile of greenbacks in lighter fluid and set them ablaze, as all your possible wants have been satisfied?

Human demand is infinite. As economist Ludwig von Mises theorized nearly a century ago, people act in order to achieve ends. If all wants are satisfied, then man does not act.

If you have had the pleasure of listening to mainstream economists in the higher reaches of academia or on the New York Times editorial page, you have been told that the current economic slump in the U.S. is due to a lack of aggregate demand. The conventional wisdom goes like this: consumers, who are deleveraging large amounts of accumulated debt, have cut down on spending. Businesses see a lack of demand and are reluctant to invest in new equipment and hiring. Therefore, the government must take up the slack. How else will the overly simplified macroeconomic formula of consumption + investment + government = GDP be maximized?

Since consumer expenditures make up 70% of the economy, the "lack of aggregate demand" explanation behind economic slumps seems simple enough. To Keynesians, the economy is a circular machine than just needs a measly trillion dollar injection to spin faster.

But herein lies the problem. Economics is called a dismal science not because of its simplicity, but because of its complexity.

If Congress could just spend endless amounts of money to supplement consumption, then the Great Depression would have ended a decade sooner and the current unemployment rate wouldn't be hovering around 9%. As Harvard economist Greg Mankiw recently pointed out, not enough juicing of aggregate demand is never the whole story:

University of Chicago economist Casey Mulligan offers a challenge to that view. Casey points out that there is a regular surge in teenage employment during the summer months because more teenagers are available to work (that is, the supply of their labor has increased). That is no surprise: It is normal supply and demand in action. But if aggregate demand were the main constraint on employment, this increase in supply should not translate into higher employment during deep recessions such as this one. But it does!

What's at work here is the fundamental concept of Say's Law that Keynes failed to disprove: markets clear. A perceived lack of aggregate demand doesn't mean products won't get purchased. Every consumer good is bought if the price falls low enough. Producers must find this price in order to adopt a new production structure to begin meeting this demand. Most people aren't going to pass up a 36-inch television for $5 at Best Buy. Sure, the television producer may fail to garner a profit on this new sales price, but that is why price signals are so important. They tell producers the structure of production can be adjusted in order to meet this new equilibrium. Capital not allocated to producing 36-inch televisions means investment in more profitable operations.

Armchair economists like to assume that human action is predictable and calculable. But action, based solely on individual preference, isn't measurable with econometric formulae.

Increased production financed through accumulated savings drives sustainable growth. This goes hand in hand with entrepreneurial seeking of unmet demand, not aggregate demand in general. Steve Jobs didn't create the iPod because consumers were spending at Walmart. He speculated that there was a demand for a portable device that could store a massive amount of music, designed the product, determined the marginally profitable price it could be sold at, and decided whether or not to risk his capital and make the whole thing happen. He could have been wrong, but thankfully for all of us, he wasn't.

Keynesian focus on aggregate demand misses the big picture. Taken to its extreme conclusion, overconsumption can ultimately lead to higher prices as supply diminishes and production can't keep up. Inflation only exacerbates the situation as wages and prices eventually adjust after distorting the structure of production.

Meanwhile, the real barriers holding back economic growth are unacknowledged by government apologists acting as economists. The prospect is what Robert Higgs deems "regime uncertainty," where the threat of increased taxes and regulatory enforcement is simply tossed away with academic hand-waving. Artificially low interest rates from the Fed have disincentivized savings and pushed investment toward riskier assets. Capital becomes difficult to accumulate, and the economic pie is prevented from expanding.

Aggregate demand is the last vestige of economists who believe that prosperity is but a simple math formula away. Those who hold it truly believe that government spending on anything creates wealth. As Paul Krugman admitted:

As far as creating aggregate demand is concerned, spending is spending - public spending is as good as but also no better than private spending, spending on bombs is as good as spending on public parks.

Such a candid statement reveals the true nature of Keynesianism. Any merit it had as an economic theory has been replaced with providing cover for politicians to do what they do best: fund special interests. When digging ditches became a solution to joblessness, Keynesianism should have been relegated to the dustbin of history. Instead, it litters college textbooks to this day.

With theories like this passing as conventional wisdom, is it any wonder why our economic affairs are in such disarray?